A storm brewing

Exchange traded funds are changing the traditionally structured managed fund market in Australia, with impacts both on adviser options and distribution channels.

GO BACK a decade and a half, and few advisers would have heard of – let alone recommended – exchange traded funds (ETFs).

However, the wealth management landscape in Australia is changing, with some planners now bypassing the major distribution channels and using these securities to build their own modelportfolios – something to which the major platform providers have yet to adapt fully.

“These big organisations have to realise – [but] the thing is they won’t, they will never admit – that there is more to their business model, their business model isfund manager-driven, commission-driven,”

Matthew Kidd, managing director of Omniwealth tells ifa.

The boutique firm believes the advisory community is heading for a split, with some planners going “down the road of direct and looking at ways to add value off-platform”, and others using “mainstream, big dealer groups, managed funds and big platforms”.

The Australian market for ETFs, however, is still small – according to a June 2013 BetaShares ETF report, it has a market capitalisation of $7.63 billion. But it is also growing rapidly, and faster than the traditional managed fund market.

“The combined annual growth rate for the ETF market since 2004 has been around 30 per cent,” Alex Vynokur, managing director of BetaShares states in the report.

“That is obviously a very fast growing market [and that is] against the broader managed funds industry, which has been growing at a significantly [slower] pace.”

BetaShares believes the introduction of the Future of Financial Advice (FOFA) reforms is putting ETFs on “a level playing field against traditional managed funds” since funds no longer have “a commission based incentive for the distribution”.

Market Vectors, another issuer in Australia, argues the appeal of ETFs is also their “efficient settlement ability”.

“People are moving away from the traditional managed fund and platform model... ETFs [are] listed on the ASX, where they get complete automated CHESS [Clearing House Electronic Sub-register System] connectivity with a platform,” Arian Neiron, Market Vectors’ managingdirector, explains.

Mr Neiron believes this is giving “various dealer group investment committees a lot to think about”.

Nonetheless, according to Omniwealth, 80 to 90 per cent of the distribution of products is dominated by the big institutions – AMP, NAB, Westpac, Commonwealth Bank and ANZ – which tend to distribute funds into their existing managed products.

“The main companies here that are providing ETFs, they are all foreign companies that basically see Australia as an untapped market... It just shows where our market is heading, but the big five are not catering for it,” says Andrew Zbik, an Omniwealth senior planner.

Mutual funds vs ETFs

Australian investors who want to track an asset have tended to achieve this via index managed funds purchased on a major platform rather than via an ETF traded on an exchange.

“The designers suppose it to be similar,” Nimalan Govender, an ETF analyst at van Eyk explains. “Index funds typically tend to be a little more costly than ETFs, but still at a lower cost to access than managed funds... [and] the index fund... [is] set up more as a mutual fund.”

Vanguard, which provides an array of index funds as well as nine ETFs that the company distributes direct and on some of the major platforms, believes there is a case for both options.

“If you were drip feeding more regular amounts into the market an [index] fund might be more suitable because you are not going to pay a brokering cost every time you trade,” Robyn Laidlaw, head of product and marketing, says.

However, according to Mr Neiron, compared like for like, index funds will “potentially lose flows to ETFs”.

“A listed version of an index is a preferable version ... just by virtue of the fact that ETFs are an investment vehicle that offer that liquidity and have that transparency through having that NAV [Net Asset Value] or intra-day NAV,” Mr Neiron says.

Market Vectors also points out there is a tax cost for index (and managed) funds distributed on platforms.

“[Unlisted funds] have got this problem called ‘last man standing’, where the last unit holder or the last investor left in the fund will bear the capital tax issues,” Mr Neiron says, adding that with an ETF, “the opposite actually happens – the retail client does not bear [the tax]... they just buy and sell it like they do with any security on the ASX.”

Omniwealth would appear to agree.

“It does not make any sense at all in our world – why would you have an index fund when you can buy the index?” Omniwealth’s Matthew Kidd says.

But how do ETFs stack up against actively managed funds.

According to a recent Standard & Poor’s Indices Versus Active report, over a five-year period, around 70 per cent of actively managed funds failed to beat the ASX/200 index.

“Chronic under-performance in the world of actively managed funds will continue to be under pressure because the availability of alternatives such as ETFs continues to expose the pros and cons,” BetaShares’ Mr Vynokur says.

According to Omniwealth, outperforming the ASX/200 is also very difficult for large cap managers since it is a very concentrated market dominated by banks and mining, which easily moves the index.

“You still have to have pretty much the same as an index, with some sort of tracking to give you some alpha – generally speaking the Aussie market is not broad enough to get away [with that],” Mr Kidd explains.

There is also “a disparity” out there, according to Mr Kidd, who says he knows for a fact that “there are some large cap fund managers that are using ETFs as their core in their fund, yet charging quite a lot more than the ETF itself.”

In terms of costs, ETFs tend to be cheaper to use than managed funds.

“ETFs have set a really good line in the Australian market in terms of the MERs [management expense ratios] that they charge,” Ms Laidlaw states, adding that “if they reduce the cost to invest, then that is a great outcome for investors, and that would be something that we at Vanguard would be very happy about”.

According to Omniwealth, however, comparing the cost of the two vehicles is not always easy.

“When you are looking at a platform, it is net of MER so the client does not technically see the cost of that managed fund. They don’t take that into consideration, but they should,” Mr Kidd says.

Craig Keary, AMP Capital’s head of retail and corporate business – who notes the financial services group is “not an ETF provider at the moment” – believes comparing the two vehicles is not comparing like with like.

“One is a passive vehicle that is low touch, and the other one is an active vehicle that is higher touch – it is actually not fair,” he says.

Advisers are, however, comparing the performance and costs of the two vehicles.

“If you have a managed fund that hugs the index very closely, I think there is a very close correlation between the two,” Mr Kidd states.van Eyk’s Nimalan Govender adds that ETFs have a high degree of transparency since investors can see the holdings, and the NAV of the security is published on an (intra) daily basis.

“The thing with most unit trusts [i.e. unlisted funds], you will have to wait two months in [or] a quarter in, then you get a sense of what a manager has transacted and what the eventual holding of the portfolio is. With an ETF it is very different, because you know what the underlying is,” Mr Govender says.

“That is really the crux of the ETF – it gives you the ability to look at the underlying securities,” Mr Neiron adds, “and the ability to do so, versus a managed fund is 10 times better”.

Market Vectors believes this will “potentially” lead to some “consolidation on the active management side”; however, this does depend on “how those firms actually align themselves in this new world”.

ETF issuers and clients

The Australian ETF market has traditionally been dominated by indices that track the major assets or exchanges, but with new players entering the market they are launching more tailored, specific products for clients.

“When you look at Vanguard and the likes of [BlackRock’s] iShares, to an extent they are doing close to vanilla exchanges... BetaShares is looking at more where the client demand is... they offer a differentiated offering, away from equities and fixed income,” Mr Govender says.

But who exactly are the purchasers of ETFs?According to Vanguard’s Ms Laidlaw, the retail direct market has been early adopters of the products and, in particular, those advisers working in the self-managed super fund (SMSF) space.

“This is somewhat different to the US where they were introduced as an institutional product to start with,” she says.

Omniwealth, which has been using ETFs both for its small and its large balance clients on platforms such as NetWealth and Mason Stevens, believes you can bypass the major providers if you want to.

AMP points out, however, that avoiding the major platforms means you do lose some of the “auxiliary benefits”, such as consolidation of reporting of your financial affairs.

According to BlackRock, there are now signs these securities are being distributed on the larger platforms.“We have seen a substantial uptick in advisers accessing iShares ETFs via both new and established wrap platforms. Most platform providers have responded well to the changing needs of their clients,” Mark Oliver, head of retail for BlackRock Australia, says.

Indeed, Mr Vynokur of BetaShares sees indications that a “virtual circle” is developing where “research houses are investing the resources to provide research on ETFs and that research is certainly finding its way to the dealer groups and from that we are seeing the addition of ETFs onto various APLs [approved product lists] and model portfolios.”

Portfolio construction

Advisers in Australia have traditionally gained their exposure to a wider range of asset classes through the big dealer groups and their products rather than direct on exchanges or via ETFs.

“I am a big believer that asset allocation is critical and with asset allocation you need to be able to access a wide range of asset classes at different times of the cycle, and you can’t get all of those exposures via ETFs,” AMP’s Mr Keary says.

However, BlackRock, which offers advisers a range of “illustrative ETF portfolios”, believes broad asset exposure can be achieved via ETFs.

“With the advent of fixed income ETFs in March 2012, and the continued expansion of the range of ETFs available on the ASX, I believe that ETF models are viable,” Mr Oliver says.

According to Mr Neiron of Market Vectors, planners’ ability to use ETFs to achieve this exposure can be seen as “a tipping point” and “further improve[s] on diversification opportunities and liquidity opportunities” available to clients and advisers.

Omniwealth uses New York-based research firm AltaVista. “There are a myriad of ETFs we can use – if you have got a mandate, they will be able to fill that mandate in relation to the asset classes,” Mr Kidd says.

Indeed, the ability to gain this diversity of asset exposures via ETFs strikes at the asset allocation benefits of the managed funds industry and big platforms – something which Omniwealth points out allows advisers – and not just asset managers – to provide that “degree of active management for clients that they previously wouldn’t receive”.

The road ahead

So, what will the future wealth management landscape in Australia look like? According to BlackRock, there is actually a template out there.

“It is interesting to note that over the last 10 or so years, the Australian and Canadian ETF markets have grown at an almost identical pace,” Mr Oliver explains. “The main difference is that Canada, which was home to the world’s first ever ETF, had a decade or so head start.”

The Canadian ETF market, valued at US$57 billion, is a lot more diverse, something BetaShares believes was one of the drivers of its growth.

“What we are finding is in markets like Canada, products and continued evolution of investment options has driven demands... And we expect continued adoption of ETFs in Australia, driven by innovation and continuing offering of new investment products to market,” Mr Vynokur says.

The BetaShares managing director also expects demand to be driven by an “increased investor awareness and increased level of education about ETFs in Australia”.

Omniwealth, however, believes some of the bigger platform providers are being “short sighted” in not realising there is “more to their business model than providing managed funds”.

Indeed, there are already signs of a schism developing between advisers using the traditional funds management structure and those using ETFs –as one anonymous financial planner with 26 years’ experience told ifa.

“Advisers using systems and products like managed funds as if we were still advising in the ‘80s and early ’90s need to step up for their clients and drag themselves into the modern world.”. «